Several factors are relevant when we consider making an investment abroad. For example, the form of investment contemplated, the structure of the organisation and the type of anticipated income to be derived are all important factors for consideration. There are numerous factors having an impact on investments. This article concentrates on the four key building blocks that influence decision-making in this regard.
Key variables of investment structuring
In order to achieve investment goals, tax treaties are designed to determine which country has the primary right to tax income - the country in which income arises (the source country), or the country in which the taxpayer is resident (the residence country) - and establish terms for the taxation of cross-border income between the signatory countries. The first thing any tax practitioner must do, therefore, is to determine whether a tax treaty is applicable.
1 The United States has signed over 50 bilateral tax treaties with different jurisdictions, and this fact provides a good chance to an investor to derive the benefits of a tax treaty. A client may be confronted with a country that may not have concluded a bilateral tax treaty with his home country. Investment in such jurisdictions will expose the investor to the full effects of the foreign jurisdiction's tax system without protection. Such situations may require some alternative structures for investment being made. Although a treaty may exist between the investor's home country and the country in which an investment is being proposed, yet the provisions of that treaty may not be favourable to the investor compared to the other bilateral tax treaty. Accordingly, even an investment in a jurisdiction possessed of a tax treaty may still require the need for some alternative tax structuring.
For this reason, many tax structures utilise intermediate holding companies in jurisdictions other than the one in which the ultimate investment lies. Though holding companies serve a number of corporate and administrative purposes, they are, perhaps, most often utilised by tax practitioners to obtain favourable treaty benefits.2 Practitioners repeatedly place such holding companies in the same jurisdictions. That is no accident. These jurisdictions tend to have favourable tax rates, low administrative tax burdens, and a wide-range of treaties available.
3 A "Permanent Establishment" is commonly defined as a "fixed place of business through which the business of an enterprise is wholly or partly carried on." 4 The OECD Commentary imbues further meaning into the term "fixed place of business, stating that a place of business must be "fixed" to constitute a Permanent Establishment, as determined both by "location" and by "time."5 Most treaties, including the US Model Treaty and most older versions of the OECD Model Treaty, also include a specific (but not exclusive) list of types of business locations that qualify as a Permanent Establishment.6 Tax treaties generally provide a list relatively similar to that provided in the US Model Treaty.
Most bilateral tax treaties between the United States and European countries generally follow the US Model Treaty. A far greater challenge is provided by the investments being made in Asia. There exists several United States bilateral tax treaties with the Asian countries, which significantly expand the definition of Permanent Establishment.7 From an Asian perspective, it is important to discuss Permanent Establishment issues with a local body and to structure the client's investment accordingly.
Gain from the sale by a foreign resident of shares of a domestic corporation is not subject to tax in many jurisdictions. Although section 861 of USC specifically lists interest, dividends, royalties, and real property sales as United States source income,11 section 865 of USC sources income from the sale of personal property to the country of residence.12 In effect, the United States will not impose withholding tax on a non-resident selling personal property, even if the property disposed is located in the United States. This allows foreign investors to purchase, and later sell, shares of US corporations without incurring US capital gains taxes.
Tax treaties, contain Capital Gains provisions that source gains from the sale of personal property to the residence of the seller.13 For example, the sale of shares of stock by a non-resident, which does not have a PE, is not subject to taxation. The fact gains importance since many countries do not exempt foreign investors from capital gains taxes on sales of shares of corporations incorporated in their jurisdiction. If the other country imposes capital gains taxes on the sale of shares of a domestic corporation, the United States investor would need to rely upon the tax treaty to ensure that it was not subject to capital gains taxes and that the purchaser would not be required to withhold taxes under local law.
Most US bilateral tax treaties with the European nations contain a capital gains provision that follows the Model treaty to the letter. The contrast that, however exists is with the capital gains articles contained in the bilateral tax treaties conducted between the United States and Asian jurisdictions, particularly China and India. These articles generally impose capital gains taxes on foreigners who sell shares of a domestic corporation.14 This state of affairs, of course, seriously affects the method by which US investors would seek to structure investments when they venture into China or India. To minimise, or eliminate, the impact of capital gains taxes, and other tax issues, practitioners should consider using one of multiple tax strategies.
Strategy 1: The holding company structure to eliminate capital gains tax
A practitioner should 'treaty-shop' to locate a bilateral tax treaty between the country of investment and a third country possessed of a more favourable capital gains provision than the United States' treaty.15 For example, a US investor considering an investment in India may, form a subsidiary corporation in Mauritius, which, in turn, may invest in the Indian corporation. At an exit time, the Mauritius subsidiary may sell the shares of the Indian company and invoke the protections in the India-Mauritius tax treaty to avoid Indian capital gains tax.
There are, however, limitations to the 'treaty-shopping'. For example, a tax treaty may provide beneficial treatment though, yet the Indian taxing authority may, nevertheless, appeal to the judicial system to prevent abuse of the Mauritius tax treaty. Several decisions over the years have imposed increasing "substance" requirements on the Mauritius entity claiming treaty benefits. Nevertheless, it has been a historically easy and a formula-driven method by which to qualify for treaty benefits. Commentators have been stating that India is going to "shut the door" on the Mauritius loophole for almost 20 years, yet, the opportunity to invest through Mauritius still exists.
Beneficial treaty arrangements involving other Asian countries also exist,16 and it is advisable to ascertain where the most benefit lies. Caution should be exercised, however, since treaties are subject to renegotiation more freely in Asia than in the United States or Europe. Caution should also be exercised to ensure that the Treaty does not contain an "Anti-Treaty Shopping" provision, or a "Limitation of Benefits" provision that would prevent the Holding Company from claiming the treaty benefits of the bilateral tax treaty with the source country.
Strategy 2: Use of a holding company in a tax haven. The second method typically utilised by tax practitioners for avoiding capital gains taxes is the insertion (or "stacking") of an extra holding company in a tax haven jurisdiction. At the time of disposition, the investor will avoid the direct sale of the shares of the target corporation by instead selling the shares of the holding company.17
Thus, direct sales of Indian and Chinese companies are typically avoided by forming a holding company in a third jurisdiction. The holding company will then be the ultimate entity to be sold by the investor. The sale of the holding company effectively avoids the capital gains taxes in those jurisdictions. The jurisdiction where the holding company resides is typically a jurisdiction that does not impose an income tax (eg, the Cayman Islands) no additional tax burden exists by virtue of selling the holding company shares. However, if the investment requires placing a holding company in a jurisdiction that imposes tax, investors tend to favour jurisdictions that impose minimal taxes (eg, Mauritius) or have a system of taxation that exempts capital gains taxes (eg, Hong Kong).18
An example of an attack on entity stacking - the Vodafone case In the landmark case of Vodafone International Holdings B.V. v. Union of India et al,19 the Indian taxing authorities asserted jurisdiction over the sale of a company holding shares in an Indian entity. So far, the tax authorities have won, and this fact may completely alter the manner in which capital investment is conducted in India. The case could also wider ramifications since other developing nations could use the case to expand their own abilities to impose capital gains taxes on foreign investment.
Vodafone involves the sale of a controlling stake in an India-based Hutch-Essar. Rather than sell the shares of the Indian corporation, Vodafone (through a Dutch subsidiary) purchased the shares of an intermediate holding company that owned a 67% stake in Hutch-Essar from Hong Kong-based Hutchison Essar. Because the transaction did not involve the purchase and sale of any Indian shares, Vodafone and Hutchison took the position that Indian taxes did not apply, and Vodafone did not withhold any capital gains taxes on the payment to Hutchison. Vodafone asserted that India does not have jurisdiction to tax transfers of ownership of a foreign corporation in another jurisdiction. However, it may be stated that this area is fraught with risk as there are divergent rulings both from the UK and other countries.
Accordingly, the Indian taxing authorities asserted that the transaction was subject to Indian capital gains tax, and that Vodafone should have withheld 2 billion in taxes. The Indian taxing authorities, moreover, took the broader position that the holding company merely held shares of the Indian corporation, so that the transaction was really an indirect transfer of an Indian capital asset. Vodafone has lost on several procedural grounds and may have to try the case in the Indian superior courts. Nevertheless the issue has allowed India to assert tax on any transfer of shares of any corporation anywhere in the world if the entity's underlying asset is shares of an Indian corporation.
Conclusion The purpose of this article was to provide practical tips on how to structure foreign investment in light of the complicated web of tax laws, tax treaties and other international agreements. In effect, the practitioner should now be armed with a plan and methodology for analysing a cross-border investment. However, providing tips, plans or basic methodology for analysing the problems is no substitute for a practitioner rolling up his or her sleeves and carefully studying the particular facts and law relevant to the client's specific transaction.
1. Because most tax treaties are bilateral arrangements between two countries, in multi-jurisdictional investments, a practitioner may need to look at multiple tax treaties and the interplay between them.
2. For example, a company located in Country A wishes to invest by purchasing shares in a company incorporated in Country B (assuming it will receive dividend distributions and may eventually sell the stock at a significant profit). Assume that there is no tax treaty between Country A and Country B (or that the treaty does not have favourable provisions). However, there is a comprehensive tax treaty between Country A and Country H, and between Country B and Country H. Both of these treaties effectively eliminate any withholding taxes on dividend payments to foreign persons in the two countries and exempt capital gains from source based taxation. It would be more favourable for the investor to form a holding company in Country H that would purchase and hold the shares of the company incorporated in Country B.
3. The Permanent Establishment concept is a key building block because it determines whether the business operations will be subject to the general income tax rules of a particular jurisdiction. For example, assume that a company in Country A wishes to expand its sales activities into a foreign Country B. If the company avoids being deemed to have a Permanent Establishment, then the company will not be subject to general County B income taxes on its sales activities. The company would only be subject to its County A taxes as usual. Country B would be limited to taxing the company under other specialised articles (eg withholding taxes) where the nature and scope of the Country B taxes is minimised, Conversely, if the sales activities in Country B rise to the level of a Permanent Establishment, then the company will be subject to Country B income tax (like any other Country B business operation) on all profits attributable to the Country B.p
4. See, eg, OECD Model Tax Treaty, Article 5(1).
5. See Commentary on the Articles of the 2005 OECD Model Income and Capital Tax Convention, July 15, 2005, Article 5 para graphs 5 and 6.
6. See, eg, Article 5(2) of the US Model Treaty, which lists some examples of "places of business," including: a "place of management"
-- a branch
-- an office
-- a factory
-- a workshop
-- a mine, an oil or gas well, or any other place of extraction of natural resources.
7. India, for example, has taken a particularly aggressive approach in defining "Permanent Establishment." See, United States-India Tax Treaty, Article 5(2). As a result, many investments into India are far more likely to qualify as a Permanent Establishment and, hence, trigger foreign taxation. In addition, India continues to take an aggressive stance with respect to agency and other Permanent Establishment issues. Likewise, has China proven far more aggressive in asserting Permanent Establishment than the UK, or other European jurisdictions. See, US-China Tax Treaty, Article 5(3).
8. Payments subject to withholding taxes include: interest, dividends, rents, royalties, and certain gains from the sale of real and personal property.
9. For example, the United States typically taxes payments of passive income to foreigners at 30 percent. However, most bilateral tax treaties reduce the rate on payments to 15 percent or less.50 This is generally much lower than the general 35 percent rate of tax that would apply if the foreign investor was deemed to have a Permanent Establishment.
10. For example, an investment fund in Country A purchases shares in a company incorporated and doing business in Country B. After the value of the Country B company has increased significantly, the investment fund sells the shares of the company resident in Country B.
11. 26 USC 861 (a).
12. 26 USC 865(a).
13. Article 13(6) of the US Model Treaty provides: "Gains from the alienation of any property other than property referred to in paragraphs 1 through 5 shall be taxable only in the Contracting State of which the alienator is a resident.
14. For example, the capital gains article from the bilateral tax treaty between China and the United States effectively taxes a United States person who invests in shares of a Chinese company if they own more than 25% of the shares. See, US-China Tax Treaty, Art. 12(5). India possesses an even more draconian provision that, in effect, allows each jurisdiction to impose capital gains taxes without limitation. Unlike a sale of shares of a United States corporation by a foreign resident, a sale by a United States resident of shares in an Indian corporation will generally attract a capital gains tax in India See US-India Tax Treaty, Art. 13(1).
15. For example, Mauritius has a tax treaty with India that has advantageous capital gains tax provisions. Most importantly, a sale of Indian shares by a Mauritius company is not subject to Indian capital gains. Mauritius once had a tax treaty with China that provided the same exemption, but that has recently been amended.
16. For example, the tax treaty between Korea and Belgium has a favourable capital gains provision that prevents Belgian investors from paying Korean capital gains taxes. Belg.-Kor., September 19, 1979, 1196 UNTS 189, Reg No 19004, Article 13. However, the exemption has recently been under attack by the Korean taxing authorities. In addition, Article 16 of the Korea -United States tax treaty provides for a complete exemption from Korean capital gains tax on a sale of Korean corporate shares by a US resident
17. For example, an investor in Country A wishes to invest in shares of a company incorporated in Country B. Country B imposes a capital gains tax on the sale of shares of a domestic corporation and there is no relief under the bilateral tax treaty between Country A and Country B. The investor in Country A forms a Cayman Islands corporation to invest in and hold the shares of the company in Country B. At disposition, the investor sells his shares of the Cayman Islands corporation (the Cayman Islands does not impose any capital gains taxes). Since there was no direct disposition of shares of the Country B entity, there is no capital gains transaction that would be subject to taxation by Country B.
18. In Vodafone International Holdings B.V. v. Union of India et al,, Indian taxing authorities attempted to assert jurisdiction over the sale of a company holding shares in an Indian entity. The Vodafone case involved the-sale of a controlling stake in India- based Hutch-Essar. Rather then sell the shares of the Indian corporation, Vodafone (through a Dutch subsidiary) purchased the shares of an intermediate holding company that owned a 67% stake in Hutch-Essar from Hong Kong-based Hutchison Essar. Because the transaction did not involve the purchase and sale of any Indian shares, Vodafone and Hutchison took the position that Indian taxes did not apply, and Vodafone did not withhold any capital gains taxes on the payment to Hutchison. The Indian taxing authorities are taking the broader position that the holding company merely held shares of the Indian corporation, so that the transaction was really an indirect transfer of an Indian capital asset.
19. Vodafone International Holdings B. V. v. Union of India et al., Writ Petition No 2550 of 2007, High Court of Judicature at Bombay (December 3, 2008).
(The writer is an advocate and is currently working as an associate with Azim-ud-Din Law Associates)